THE UNIVERSAL SERVICE PROGRAM: A …/media/assets/2012/03/28/universal-service...THE UNIVERSAL...

THE UNIVERSAL SERVICE PROGRAM:

A REGULATORY SUBSIDY CASE STUDY

prepared for

The Pew Charitable Trusts

by

Gerald Brock and April Corbett

March 28, 20121

The authors are affiliated with the Trachtenberg School of Public Policy and Public

Administration at the George Washington University. Brock is a Professor of Telecommunication

and of Public Policy and Public Administration. Corbett is a graduate of the Master of Public

Policy program.

1 Note: This paper is based on 2007-2008 data, which was the most current available at the time of the analysis in

2010. It does not discuss the 2011 changes to the program.

THE PEW CHARITABLE TRUSTS

The Pew Charitable Trusts is driven by the power of knowledge to solve today’s most

challenging problems. Pew applies a rigorous, analytical approach to improve public policy,

inform the public, and stimulate civic life.

SUBSIDYSCOPE

Subsidyscope aims to raise public awareness about the role of federal subsidies in the economy.

The project aggregates information on federal spending and subsidies from multiple government

sources, serving as a gateway for press, policy makers, advocates, and the public. The

comprehensive and objective data presented by Subsidyscope will contribute to an informed

debate about how to best allocate scarce government resources.

TEAM MEMBERS

Susan K. Urahn, Managing Director, Pew Center on the States

Ingrid Schroeder, Project Director

Lori Metcalf, Project Manager

Andreas Westgaard, Associate

John Burrows, Administrative Assistant

ACKNOWLEDGEMENTS

We would like to thank all team members, Gordon McDonald, Samantha Lasky, Jeremy Ratner,

Sarah Holt, Liz Gross, Gaye Williams, and Joseph V. Kennedy for providing valuable feedback

on the report.

The report benefited from the insights and expertise of two external reviewers: Benjamin

Lennett, Policy Director for the Open Technology Initiative at the New America Foundation, and

John Morrall, an affiliated senior scholar at the Mercatus Center at George Mason University. We

also received helpful comments from Robert Dennis, former assistant director, Macroeconomic

Analysis Division, of the Congressional Budget Office. Although they reviewed drafts of the

report, neither they nor their organizations necessarily endorse its findings or conclusions.

For additional information on Subsidyscope, please visit www.subsidyscope.org or email us at [email protected].

© March 2012

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mailto:[email protected]

Page | 1 The Universal Service Program Subsidyscope

I. Introduction and Summary

The Universal Service Fund (USF) currently distributes more than $7 billion per year

among participants in the telecommunication industry. It is a regulatory cross-subsidy system

that is determined by the rules of the Federal Communications Commission (FCC) and the

administration of those rules. The USF affects consumers through higher prices for subscribers

to services that pay into the fund and lower prices for subscribers to services subsidized by the

fund. Companies pay into the fund 14 percent of their revenue derived from interstate long-

distance calls and 5.2 percent of their revenue derived from cellular service. The companies

charge customers for the fees they are required to contribute to the USF; consequently, the USF

increases consumer prices by about 14 percent for interstate long-distance calls and by about 5

percent for cellular service.

The USF subsidizes four categories of service. As of 2007 (the most recent year for

which fully stabilized data are available), the largest portion (62 percent of the fund) subsidizes

companies serving rural, high-cost areas. The companies with the highest cost per telephone line

receive most of this subsidy money. Within the category of high-cost loop support payments

made to incumbent local exchange carriers, about half of the subsidy goes to companies that

provide the 1 percent of all telephone lines that have the highest cost.2 The money goes to the

telephone companies; however, they are expected to reduce their rates to customers because of

the subsidy. The second-largest category of payments (25 percent of the fund) is used to

subsidize communication and Internet services for schools and libraries. The third category (12

2 This calculation was conducted with information from the FCC, 2009 Monitoring Report, Tables 3.22 and 3.31.


percent of payments) subsidizes basic telephone service for low-income individuals. The final

category (1 percent of the fund) subsidizes communication for rural health-care providers.

The universal service program provides a good example of how regulation can create

subsidies because it has taken three forms over the past half century. At first, when the industry

was monopolized, the program created the subsidies by regulating the prices of local service and

long-distance service. As competition emerged, the mechanism to create the subsidies shifted to

regulatory control over the terms and conditions by which companies interconnected their lines

and transferred calls among themselves. Finally, the FCC changed the program to the current

approach of explicit charges to specified service providers and payments to others. Each form of

the program illustrates a way in which regulation can create subsidies.

II. Three Types of Regulatory Subsidy

Economic regulation routinely creates cross-subsidies among various classes of users.

Robert Horwitz has described the cross-subsidies as an intentional component of New Deal

regulation designed to provide universal access to infrastructure industries: “New Deal ...

regulatory agencies formulated complex rate structures to cross-subsidize certain types of routes

and services. ... The economic consequence of this was to stabilize and universalize the

infrastructure for commerce.”3 The pattern he described for New Deal regulatory agencies in

general applied to the FCC’s regulation of telephone service. The Communications Act of 1934

created the FCC, giving it jurisdiction over telephone service and broadcasting. Section 1 of that

Act stated as its mission: “For the purpose of regulating interstate and foreign commerce in

communication by wire and radio so as to make available, so far as possible, to all the people of

3 Robert Horwitz, The Irony of Regulatory Reform: The Deregulation of American Telecommunications (Oxford

University Press, 1989), pp. 74, 75.


the United States, ... a rapid, efficient, Nation-wide, and world-wide wire and radio

communication service with adequate facilities at reasonable charges.”4 The emphasis on

making service available “to all the people of the United States” provided statutory justification

for FCC actions to promote widespread service, but the act did not provide details about how to

accomplish that goal.

The first stage of universal service subsidies occurred through regulating the price

structure for telephone services (local residential, local business, long-distance toll service, etc.).

In an unregulated competitive market, the structure of prices will follow the structure of costs

incurred in providing the various services. If the price structure is controlled by regulation or

statute, political forces rather than costs will determine the price structure.

The Post Office provides an early example. Before 1845, postage was computed based

on the mileage traveled, but after an 1851 law changed the rate structure, it was computed at a

rate of three cents per letter to anywhere in the country. This created an implicit subsidy

structure with those who sent letters to remote areas receiving service below cost and those who

sent them short distances within major cities receiving service above cost. Similarly, within the

regulated telephone industry, prices needed to be high enough to cover the cost of providing

service (including depreciation and return on capital) as defined by the regulatory accounting

system. Many combinations of prices for different telephone services could provide the target

level of revenue, and cross-subsidies could be created or increased by changing the relative

prices for services while keeping the total revenue constant.

Subsidies to promote universal service began with regulatory decisions in the 1950s to

shift some of the burden of paying for the telephone network from local subscribers to those who

made interstate toll calls. That shift reduced the price for basic local service and increased it for

4

47 U.S.C. 151


interstate toll calls. At the time, the telephone industry consisted of the dominant integrated firm

AT&T—which monopolized long-distance service and also provided local service to most

subscribers in the country through its subsidiaries, known as the Bell Operating Companies—and

many small, independent companies that provided service to rural areas and small towns. The

FCC regulated AT&T’s interstate long-distance service, and each company providing local

service monopolized a specified geographic area and was regulated by the relevant state public

utility commission. Because of the multiple companies and regulatory authorities, the process of

shifting the relative costs of local and long distance service was complex and required agreement

between state and federal regulatory authorities.

As technological progress reduced the cost of providing long-distance service, regulatory

actions kept those rates approximately constant. This created increasingly profitable long-

distance service because of the growing disparity between a constant price and a declining cost

of providing service. Regulatory action transferred the excess profits from long- distance service

to the local companies (both AT&T-owned and independent). The formulas used to share

interstate toll revenue with local companies were particularly generous to small, rural companies,

and those payments covered a substantial portion of their cost. The subsidy payments from

interstate toll revenue allowed the rural companies to charge low rates to their customers and still

cover the high cost of serving them.5

When the telephone system was a regulated monopoly, any rate structure generating

enough revenue to cover all costs was economically viable, but the growing disparity between

5 The essential structure of a traditional telephone network was connecting each customer location to a central switch

with a pair of copper wires. Densely populated areas had many customers close to the central switch and could use

relatively short wires to make the connection, while sparsely populated area required long wires. The long wires

and other factors made the costs per customer increase as the population density decreased.


price and cost created incentives to challenge AT&T’s monopoly on long-distance service.6 In

1975, MCI created a service in which a subscriber could use a local phone call to reach an MCI

location, where the call would be transmitted on the company’s “specialized” communications

facilities to an MCI location near the called party and then terminated by a local call from the

MCI location to the final customer. This service directly threatened the established subsidy

structure because it allowed MCI to provide a substitute for AT&T’s long-distance service

without paying part of its revenue in subsidies to the local companies.

The FCC initially prohibited MCI's version of long-distance service, but after an adverse

court decision the agency allowed a modified version of the original service. The FCC, state

regulatory commissions, AT&T, and the independent telephone companies all opposed long-

distance competition. Those parties argued that MCI and other potential competitors were trying

to profit from the regulatory policy that used a portion of AT&T’s long-distance revenue to

subsidize local companies. The Antitrust Division of the U.S. Department of Justice viewed

AT&T's efforts to maintain its monopoly as illegal, anticompetitive behavior and filed an

antitrust suit. This resulted in the 1984 separation of AT&T’s long-distance service from the

companies providing local service, a process known as divestiture.7 The Justice Department’s

separation of AT&T into multiple companies was designed to promote competition in long-

distance service, but it assumed that local companies would retain monopoly control of their

assigned territories.

6 Even though many companies were involved, the telephone system was a regulated monopoly because each local

service company had a monopoly of its defined geographic territory and AT&T provided the only long-distance

service. 7 The divestiture agreement created eight companies out of the old AT&T. The long-distance service and

manufacturing company retained the name AT&T, and the previous AT&T local telephone subsidiaries were

grouped into seven companies known generally as Regional Bell Operating Companies. Many later changes

modified the divestiture structure, and now AT&T and Verizon both provide a full range of telecommunications

services and together provide telephone service to most of the territory served by AT&T before 1984.


The 1984 breakup of AT&T ended the first stage of the universal service program. Cross-

subsidies created by regulatory control of the rate structure could only exist in a monopoly

environment. Many analysts then assumed increasing competition would end the subsidy

structure, rather than only the form of subsidy used at that time.8 The FCC initially proposed to

phase out the subsidies, but the plan was vigorously opposed by small telephone companies, state

regulators, and influential members of Congress. The result was a complex compromise plan

that created the second stage of the universal service program (effective 1984-1997).

This program was based on creating a subsidy structure through regulating the terms and

conditions for interconnection among the companies in the post-1984 telephone industry.

Telephones are among several “network industries,” in which the value of service to a customer

depends upon what other customers can be reached through the service. No one needs a

telephone to talk to him or herself. A telephone system connecting only customers in one town is

of some value, but the service is much more valuable when connected with other systems so that

someone can reach a very large number of people. Network industries might be based on

physical connections (as in telephones and railroads) or software connections (as in Facebook

and other social media). In an unregulated network industry, the control of connections among

participating providers is a critical, competitive issue and that control can be used to create a

monopoly. In a regulated network industry, the regulators can require interconnection on terms

chosen to meet regulatory objectives.

8 For example, FCC Commissioner Anne Jones wrote in 1983: “The days are numbered for regulators who believe

they can mandate economically irrational behavior in the telephone industry. It is unrealistic to persist in the belief

that dynamic telecommunications markets will adjust to a regulator’s transition timetable to preserve “equities”

among affected market participants. . . . They are simply not viable in a dynamic growth industry such as

telecommunications.” Dissenting Statement of Commissioner Anne P. Jones, CC Docket 80-286 (released

September 26, 1983).


When long-distance providers and local telephone companies are distinct entities, as they

were in the post-1984 industry structure, the connection between the two entities benefits both

parties. The long-distance company gains value from access to the customers served by the local

company, and the latter benefits from being connected to other local companies via the long-

distance provider. There are many possibilities for dividing the benefits of interconnection:

Payments could be made by either company to the other, or they could agree to exchange traffic

without payments by either party to the other.9 The second phase of the universal service

program was created by mandating payments from long-distance providers to local companies

for each minute of conversation originated by a local company or terminated by one. The

revised program required the regulators to make a legal distinction between a local call

connected to a long-distance provider and a local call that terminates with another local

subscriber, even if the two calls are technically identical. If long-distance companies were

allowed to connect their facilities with final customers through ordinary local calls (as in MCI’s

original Execunet Service and the later dial-up Internet service), the subsidies would have been

eroded away. Instead, the FCC declared that a call to or from an interstate long-distance provider

was an “interstate access call” and would be charged at a much higher rate than an ordinary local

call, even if it was technically identical.

As long as local companies maintained monopoly control of access to the long-distance

companies, access charges could be set far above the cost of providing service and thus provide a

continuation of subsidies. The original access charges (in 1984) averaged just over $.17 per

long-distance conversation minute when the average revenue per interstate minute was $.30;

9 For example, large Internet providers often exchange traffic on a “peering” basis; that is, both agree to accept

traffic from the other without payments in either direction. For a review of types of interconnection payments used

in telecommunication, see Gerald Brock, “Unifying the Intercarrier Compensation Regime,” in Randolph May, ed.

New Directions in Communications Policy (Carolina Academic Press, 2009).


thus, the long-distance companies paid about 57 percent of the toll revenue received back to local

companies for access charges.10 The FCC closely controlled the details of the access- charge

plan in order to meet its political and economic objectives.11

The access charge plan initially

maintained most of the subsidy flows from the earlier system, but gradually reduced the

subsidies paid to large local telephone companies while maintaining and increasing the subsidies

paid to small local companies. Straightforward access charges would have directed most of the

money to the large local companies that were earlier a part of AT&T, but a complex pooling and

cost-allocation system increased the payments to small rural companies.12

Reducing subsidies to the large local companies during the first 10 years of the revised

subsidy system (1984-1993) caused the price for long-distance service and access charges per

minute of such service to decline steadily, but also increased the monthly price of local service

for most customers. The Consumer Price Index (CPI) for local telephone service rose in each of

those years, while the CPI for interstate toll service declined in eight of the 10 years. The largest

changes in both price indices occurred in 1984-1987.13

To prevent low-income consumers from

discontinuing telephone service as subsidies to large local companies declined, the FCC created a

subsidy program called Lifeline. An eligible low-income consumer received basic telephone

service at a reduced rate and the company providing the service was compensated for the

differential from the subsidy pool. The initial Lifeline program was a small part of the subsidy

program, but it represented a significant improvement in targeting subsidies to meet the stated

goal of universal service. Previous programs provided subsidies to local companies without

10

FCC, Wireline Competition Bureau, “Trends in Telephone Service” (September 2010), Tables 1.2 (access charges)

and 13.4 (average revenue per minute). 11

Although the access portion of a telephone call is physically within a single state, it is legally a portion of an

interstate call and therefore subject to the FCC’s jurisdiction instead of the state public utility commission. 12

The FCC rules regarding access charges are codified in 47 CFR 69. The political and economic issues in the

access charge plan and its implementation are discussed in Gerald Brock, Telecommunication Policy for the

Information Age: From Monopoly to Competition (Harvard University Press, 1994), chapters 10 and 11. 13

Bureau of Labor Statistics, reported in FCC, 2009 Monitoring Report, Table 7.3.


regard to their subscribers’ income level. A small company serving a wealthy resort in the

mountains would receive the same subsidy as a company with similar costs serving low-income

customers, even though the wealthy customers were unlikely to drop telephone service if their

rates were not subsidized.

The second stage of the subsidy program (access charges) was only viable with monopoly

local telephone companies because alternative methods of connecting the long-distance company

and final customers would bypass the connection generating the subsidy. Even as it created the

1984 access-charge subsidy system, the FCC recognized that high access charges could not be

sustained if competition developed in local telephone companies. The FCC’s concern that the

initial level of access charges would create incentives for entrepreneurs to develop alternative

methods of connecting customers to long-distance companies was an important part of the

justification for phasing down the general subsidy to large local companies. During the early

1990s, many small companies overcame the technical and regulatory obstacles to providing

services for large customers in competition with the local telephone company.14

At the request of

the new companies, the regulatory commissions in Illinois, New York, and several other states

relaxed their monopoly rules and developed a regulatory structure to accommodate competition

in local exchange service. During that time, wireless cellular telephones were evolving from a

specialty product to a part of everyday life.. Wireless phones were provided by both established

companies and new firms, and they offered another source of potential competition to the

incumbent telephone companies. In 1994, Congress began developing a federal statutory

framework to accommodate competition and relax the antitrust restrictions placed on the

14

The first companies were Metropolitan Fiber Systems in Chicago (later incorporated into Verizon) and Teleport

Communications in New York (later incorporated into AT&T). Both companies began operations in the late 1980’s

using high-capacity optical fiber systems to connect a small number of locations that had very dense traffic between

them.


companies created by the break-up of AT&T. That effort resulted in the Telecommunications Act

of 1996 (1996 Act), which used ideas developed by state regulatory commissions to create a

federal framework for competition in all parts of the telecommunications industry.

The FCC’s implementation of the 1996 Act created the third and current phase of the

universal service program. The 1996 Act provided the first explicit statutory guidance for

subsidies to promote universal service, but the FCC still had wide discretion to determine the

structure of the subsidies. While promoting competition, the 1996 Act required the agency to

create methods to prohibit the normal competitive adjustment of the prices of different services

to the cost of those services. It is more expensive to provide telecommunication services in rural

areas than in urban areas, but the law required that rates be essentially the same by providing that

“Consumers in all regions of the Nation … should have access to telecommunications and

information services … that are reasonably comparable to those services provided in urban areas

and that are available at rates that are reasonably comparable to rates charged for similar services

in urban areas,” and that “rates charged by providers of interexchange telecommunications

services to subscribers in rural and high-cost areas shall be no higher than the rate charged by

each such provider to its subscribers in urban areas.”15

The FCC was instructed to fund the

subsidies for equalizing rural and urban rates by requiring contributions from telecommunication

service providers: “Every telecommunications carrier that provides interstate

telecommunications services shall contribute, on an equitable and nondiscriminatory basis, to the

specific, predictable, and sufficient mechanisms established by the Commission to preserve and

advance universal service.”16

15

47 USC 254(b)(3) and 254(g). 16

47 USC 254(d).


The FCC implemented the general statutory provisions regarding universal service with

thousands of pages of orders, including more than 20 “orders on reconsideration” modifying

parts of its earlier ones. The central characteristic of the previous system (a portion of long-

distance toll revenue used to subsidize the costs of small rural companies) continued under the

new system, but there were significant changes. In the first change, the subsidy flows were made

explicit by creating the Universal Service Fund with identified contributions from long-distance

providers into the fund and identified payments to beneficiaries out of the fund. Most of the

information is publicly available, but some data on individual companies are considered

confidential and protected from disclosure. That contrasted with the previous system, in which

access-charge payments from long-distance providers to local companies were characterized as a

fee for the service of originating and terminating long-distance calls and the subsidy component

of that fee could not be easily identified.

The FCC also became responsible for administering the contributions and payments, and

thus far more deeply involved in the details of the system. Under the previous system, the

agency set the access-charge rules, but the parties involved managed the payments. The FCC

lacked the administrative capacity to collect, disburse, and audit the billions of dollars of

transfers among hundreds of companies necessary to implement the post-1996 subsidy structure.

The FCC contracted the direct administration of the system to a private company formed for that

purpose, the Universal Service Administrative Company (USAC).17

All administrative actions,

including collecting detailed data from the companies and evaluation of applications for

17

USAC is a subsidiary of a previously existing organization, the National Exchange Carrier Association, which had

administered portions of the access-charge system.


payment, are handled by USAC under the direction of the FCC.18

USAC decisions may be

appealed to the FCC.

In the third change, the universal service program was expanded to subsidize Internet

access for schools and libraries. Providing federal support for connecting schools to information

sources had been a long-standing goal of the Clinton administration and was particularly

promoted by Vice President Al Gore. The politics of the time prevented a straightforward federal

budget appropriation to finance school Internet connections, but the universal service program

could provide the financing without affecting the federal budget. With Clinton administration

support, Senators John D. Rockefeller IV (D-WV) and Olympia Snowe (R-ME) inserted a vague

provision authorizing the FCC to support “access to advanced telecommunications and

information services” for schools and libraries through the universal service program. FCC

Chairman Reed Hundt successfully sought the other commissioners’ support for an expansive

interpretation of the schools program, and it became a major part of the universal service

program.19 The agency’s use of much of the USF to promote Internet usage in schools and

libraries was challenged as beyond the Commission’s statutory authority, but an Appeals Court

allowed the program to proceed.20

The three stages of the universal service program illustrate three general types of

regulatory subsidies. The first stage (regulatory control of rate structures to meet political

18

In 2008, USAC reported $202 million in administrative expense for managing the Universal Service Program.

FCC, 2009 Monitoring Report, Table 1.10. 19

The politics of adding Internet in schools to the Universal Service Program are discussed in detail in Reed E.

Hundt’s You Say You Want a Revolution: A Story of Information Age Politics (Yale University Press, 2000).

According to his account, the goal of connecting classrooms to the Internet was developed in a senior policy

group chaired by Gore, and Hundt found an opportunity to implement a portion of that goal with

financing from the Universal Service Fund. He described the expansion of the USF into funding schools as a

central achievement of his time as chairman: “Our central effort, based on a vision articulated by Al Gore, was to

have the federal government guarantee that new communications technology would be at the fingertips of every

child in every classroom. Against vigorous political opposition, we fought from 1994 to 1997 to create the largest

national program to benefit elementary and high school education in our country’s history.” (p. x). 20

Texas Office of Public Utility Counsel, et. al. v, FCC and USA 183 F.3d 393 (5th Cir. 1999).


objectives) is routine in industries subject to economic regulation. From a customer perspective,

regulating the rate structure shifts the burden of paying for the system among classes of users.

From a supplier perspective, it changes the profitability of services. In the telephone case, the

only reason that long-distance toll service was regarded as profitable while local residential

service was regarded as unprofitable was that regulatory policies intentionally raised long-

distance rates and reduced local rates. In a completely monopolized environment, such price

controls only affect who pays but when there is the possibility of competition it affects the

incentives to enter the market.

The second stage (access charges) illustrates how regulatory control of interconnection

conditions can generate subsidies. Interconnection terms and conditions are critical to

competitive viability in a network industry. Regulators can use control of interconnection terms

to promote competition and to achieve other objectives. The FCC’s objectives in creating the

initial access-charge plan were strongly influenced by the political pressure to retain most of the

subsidy from the previous system.

The third stage of the universal service program shows that regulatory subsidies can be

generated by explicit charges to some companies and payments to others. This form creates

more information about the amount and beneficiaries of the subsidy than the previous two.

Explicit charges and payments are a less common type of regulatory subsidy than the other two

because the charges resemble a tax. Regulatory agencies are not authorized to levy a tax and

must be careful with the legal structure and justification to impose an explicit regulatory subsidy.

The FCC’s current program was challenged as an unconstitutional tax, but the agency

successfully defended it to the reviewing courts.


III. The Current Program

The FCC rules developed in response to the 1996 Act determined the basic structure of

the current universal service program. This section will first describe how the program is funded

and then describe the payments from the system. The system is funded by a prescribed

“contribution” from companies that offer services classified as “interstate

telecommunications.”21

Each quarter, the program’s contract administrator, USAC, estimates the

funding requirements for the programs in the Universal Service Fund for the next quarter. USAC

also estimates expected interstate revenue for the next quarter using detailed data provided by the

relevant companies. USAC divides its estimate of the total funding required for the quarter by

its estimate of the total revenue subject to the contribution to get a contribution percentage

factor.22

It recommends that contribution factor to the FCC and, if the agency agrees, it requires

companies to contribute that percentage of interstate revenue to the USF.

The initial source of funds for the current program was the same as in the previous

versions; the large, and then increasing, pool of interstate toll revenue. However, as the rates

charged for toll calls declined and as long-distance calls increasingly were initiated from wireless

phones with distance-insensitive rate plans, interstate toll revenue decreased. Continued reliance

on contributions from these revenues alone would have threatened the USF’s viability. The FCC

preserved the USF funding by requiring contributions from wireless carriers, even if they do not

assess a fee for interstate calls separate from their charge for local calls.23

Pricing plans that

charge the same rate for local and long-distance calls blur the distinction between interstate and

21

More precisely, telecommunication carriers are required to contribute a portion of their projected collected end

user interstate and international revenue after making prescribed adjustments to their revenue forecasts. But

interstate revenue is the dominant component, and that term will be used to designate the revenue subject to

contribution. 22

Trends in Telephone Service, Sept. 2010, Table 19.17 23

Telecommunications Industry Revenues Report, Sept. 2010, Table 12; Universal Service Monitoring Report,

2005-2009, Tables 1.10


intrastate revenue, but the FCC deems 37.1 percent of the revenue of wireless carriers as

“interstate telecommunications” and assesses the USF contribution on that fraction of revenue.24

Funding requirements for the USF programs have risen faster than the revenue subject to

the assessment, including both interstate toll revenue and the fraction of wireless revenue

deemed interstate. Consequently, the contribution factor (the percentage of interstate

telecommunications revenue that must be paid into the fund) has risen steadily and reached 14

percent in 2010. The contribution factors for 1998 to 2010 are shown in Figure 1.

24

The FCC adopted the 37.1 percent allocation of wireless revenue to interstate in 2006, after earlier using 15

percent and then 28.5 percent. The allocation was based on the highest fraction of interstate minutes observed in a

traffic study of several wireless carriers. The FCC also gave carriers the opportunity to report a lower fraction if

they could provide adequate justification. Universal Service Contribution Methodology, FCC 06-94, 21 FCC

Record 7518 (2006).

3

4

6

7 7

9

9

11

10

11

11 12

14

0

2

4

6

8

10

12

14

16

Pe

rce

nt

Year

Figure 1 Contribution Factors 1998-2010

(quarterly average)

Contribution Factor

Source: Authors' analysis of FCC Trends in Telephone Service Report, Sept. 2010, Table 19.17


From a consumer perspective, the 2010 contribution factor is equivalent to a 14 percent sales tax

on interstate toll calls that are charged for separately from monthly local telephone service, and a

5.2 percent sales tax on wireless bills.25 Many service providers show the universal service

charge as a separate line item on their bills.

The current USF supports four programs: support for high-cost telephone companies,

reduced rates for low-income individuals, subsidized communication services for schools and

libraries, and subsidized communication services for rural health care. The dominant program

(62 percent of funding) provides subsidies to telephone companies that have high costs per

subscriber, with most of the money going to those that serve rural areas.26

This is the successor to

earlier programs that subsidized high-cost companies through AT&T's toll revenue-sharing

program and the access-charge system. Complex formulas are used to compute payments to

individual companies, but the process generally favors the smallest telephone firms in rural

areas. As of 2007, almost half of the high-cost payments go to small incumbent companies

(those with fewer than 50,000 connections or “loops”).27

The remainder is split between larger

incumbent companies and the competitors to the high-cost firms that use wireless technology and

receive the same subsidy per line as the incumbent with which they compete. These payments

subsidize both the subscribers of small rural companies that get service at less than the cost of

providing it, and the owners of small rural companies who are freed from marketplace

constraints on their expense levels and earn higher profits on their invested capital than they

would without the subsidy.

25

The 14 percent assessment is applied to the 37.1 percent of the wireless bill that is deemed interstate revenue for

plans with no distinction between local and long-distance minutes, and therefore the assessment on the entire bill is

5.2 percent. 26

Universal Service Monitoring Report, 2009, Tables 3.14, 3.31, 2.4, 4.2, & 5.2 27

Ibid.


The schools and libraries program provides discounts of 20 to 90 percent on

telecommunications services, Internet access, and internal connections for schools, school

districts and libraries.28

The discount level is determined by the poverty level of the school or

area in which a library is located, as measured by the fraction of students eligible for the free

lunch program. Because the program funds services available from many suppliers, such as

internal connections to make Internet access available in classrooms, public notice, competitive

bidding and other administrative requirements were imposed to limit the opportunities for abuse

of the subsidies. However, those requirements also complicate the process and many approved

proposals are not fully carried out, causing disbursed funds for the program to be well below the

level of funding commitments. In 2007, for example, $2.4 billion was committed for funding the

discounts in approved plans, but only $1.7 billion was disbursed.29

The schools and libraries program grew rapidly in the early years, with funding

commitments rising from $1.7 billion in 1998 to $2.7 billion in 2003, but a cap of $2.25 billion

per year was imposed to limit its size.30

Schools and libraries seeking discounts file the required

information with USAC. It makes the initial decisions on eligibility, and its decisions may be

appealed to the FCC. Requests for discounts on telecommunications services and Internet access

are given priority, and the remaining money is applied to requests for internal connections,

beginning with the most disadvantaged schools (90 percent discount level).

The low-income program is a successor to the Lifeline program that began in 1984.31

It

was expanded after the 1996 Act, and more benefits for those living on tribal lands were added in

2000. A household is eligible if its income is not greater than 135 percent of the poverty level, or

28

2009 Monitoring Report, Table 4.1 29

Ibid. 30

2009 Monitoring Report; Table 4.1 and page 4-1 31

Universal Service Monitoring Report, 2009, Tables 3.1, 2.2, 4.1, and 5.1

http://hraunfoss.fcc.gov/edocs_public/attachmatch/DOC-295442A6.pdf



if it participates in one or more means-tested programs, such as Medicaid, food stamps, or free

lunches.32

Eligible subscribers receive a discount on their monthly telephone bill of

approximately $7.50.33

Those in states that have established their own low-income program may

receive an additional discount, with the costs shared between the state and the USF. Eligible

subscribers living on tribal lands receive a discount of up to $25 in addition to the basic discount,

subject to the requirement that they must pay at least $1 per month for telephone service.34

A

separate part of the low-income program known as Link Up provides discounts on initial

connection charges.

In 2007, 6.6 million non-tribal subscribers received $710.3 million in discounts from the

low-income program, for an average benefit of $8.96 per month for each participant. That year,

329,000 tribal subscribers received $73.3 million in discounts, for an average benefit of $18.54

per month for each tribal participant.35

Although tribal benefits are only about 10 percent of non-

tribal benefits, they are growing rapidly while the non-tribal benefits are approximately constant.

The rural health-care initiative is the smallest of the four programs, to the point of being

relatively insignificant.36

It provides discounts on telecommunications and Internet services

utilized by rural health-care providers. In 2007, the program disbursed $50.2 million, of which

$28.7 million (58 percent) went to Alaska and small amounts to a number of other states.37

32

47 C.F.R. 54.409 33

This amount is based on typical SLC amounts (which vary by state and are incorporated into Tier 1 support) plus

$1.75 (Tier 2 support which is not automatic but currently all states have qualified for Tier 2). 34

47 C.F.R. 54.403 35

2009 Monitoring Report, Tables 2.1 and 2.2 36

Universal Service Monitoring Report, 2009, Table 5.2 37

Ibid.


Figure 2 summarizes the revenue flows to and from the USF in 2007.38 A total of $7.28

billion was paid into the fund, of which 40 percent came from wireless service providers—the

largest single source of funds.

A total of $7.24 billion was paid out of the fund to support the four programs. The amount paid

out is routinely less than the amount paid in because the administrative expense of the program is

greater than the interest earned on the balance of funds held for later disbursement.

38

2007 is the latest year for which fully stabilized data currently are available for the entire program. More recent

data is available for portions of the program, including the contribution factor for the end of 2010 and other data for

2008 and 2009. The longest lag occurs for the schools and libraries program because funds are recorded as

committed when a plan is approved for funding, but it often requires significant time to implement the program,

receive payment, and correct any discrepancies between planned and actual expenditures.


IV. Analysis of the Universal Service Program

A. Contributions on a national level

As discussed, since 1998 the USF subsidies have been funded by a required contribution

from interstate telecommunication revenue that has risen from 5.7 percent in 2000 to 14 percent

in 2010. In the early years of the current funding mechanism, contributions were dominated by

toll service providers and the system continued the long-standing subsidy of high-cost local

services from toll revenue. A very small amount of revenue came from wireless providers and a

modest amount from the interstate services of local service providers. However, as wireless

phones with distance-insensitive pricing plans became routine, many people began making long-

distance calls from cell phones instead of traditional phones with separate toll charges; by 2006,

wireless carriers slightly surpassed toll providers in contributions to USF, with the gap

increasing annually thereafter If the current funding mechanisms remain, this trend seems likely

to continue. Wireless thus would become the dominant source of funds, while traditional toll

revenue becomes smaller.39

Figure 3 shows how the revenue contributed by providers has

changed over time.

39

FCC Telecommunications Industry Revenues Report, Sept. 2010, Table 12


B. Payments on a national level

Payments out of the USF have increased, sometimes dramatically, since its inception in

1986.40

For the decade after 1986, companies still received substantial subsidy flows from access

charges, and the high-cost expenditures rose as the subsidies were gradually shifted from access

charges to the high-cost fund. USF expenditures increased markedly in 1998 with the beginning

of the schools and libraries program. Meanwhile, increasingly generous provisions for the low-

income and high-cost programs kept both growing.41

Figure 4 illustrates the expenditures on the

fund’s four components from 1986 to 2007.

40

Universal Service Monitoring Report, 2009, Tables 3.1, 2.2, 4.1, and 5.1 41

The subsidy rules and the changes made to them are technical and complex. For a brief description of the

evolution of the low-income and high-cost program rules with references to the relevant FCC orders and sections of

the Code of Federal regulations, see FCC, 2009 Monitoring Report, pp. 2-1 to 2-4 for low-income and pp. 3-1 to 3-9

for high-cost.

0

10

20

30

40

50

60

70

80

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Per

cen

tage

Sh

are

Figure 3 Percentage Share of USF Contributions by Provider

Type 1999 to 2008

Fixed Service Local Service

Providers

Wireless Service Providers

Toll Service Providers

Year Source: Authors' analyis of FCC Telecommunications Industry Revenues Report, Sept. 2010, Table 12


Overall, payments for all four programs continued to grow after the sharp jump in 1998 from less

than $5 billion to more than $7 billion (in constant dollars) during 1998-2007. Table 1 shows the

same data as Figure 4, only in numerical form, and includes the rate of growth for each year.

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

$5,000

$5,500

$6,000

$6,500

$7,000

$7,500

$8,000

Co

nst

an

t 2

01

0 d

oll

ars

(m

illi

on

s)

Figure 4 Universal Service Fund Payments 1986 to 2007

High Cost Low Income Schools and Libraries Rural Health Care

Source: Authors' analysis of FCC Universal Service Monitoring Report, 2009, Tables 3.1, 2.2, 4.1, & 5.1


Table 1 Total Payments & Annual Growth in the Universal Service Fund 1986-2008

(constant 2010 dollars in millions) Annual

Growth in

Total Fund

(%)

Year High Cost Low Income Schools &

Libraries Rural HC Total Fund

1986 111 0 0 0 111 ---

1987 241 0 0 0 241 118

1988 338 63 0 0 400 66

1989 880 97 0 0 977 144

1990 1004 123 0 0 1127 15

1991 1211 149 0 0 1360 21

1992 1422 170 0 0 1592 17

1993 1551 190 0 0 1741 9

1994 1577 209 0 0 1786 3

1995 1619 223 0 0 1842 3

1996 1651 231 0 0 1882 2

1997 1716 219 0 0 1935 3

1998 2261 621 1872 5 4759 146

1999 2248 628 2165 6 5047 6

2000 2829 657 2088 13 5587 11

2001 3190 726 2088 23 6027 8

2002 3557 819 1931 26 6334 5

2003 3869 849 2307 31 7055 11

2004 4003 881 1762 36 6681 -5

2005 4238 895 1752 44 6929 4

2006 4444 873 1640 47 7005 1

2007 4510 866 1815 53 7243 3

2008 4534 833 1082 23 6471 19

Source: Authors’ analysis of FCC Universal Service Monitoring Report, 2009, Table 3.1, 2.2, 4.1,

and 5.1

Over time, concerns have been expressed about the unsustainable growth in USF payments and

the associated increases in the fraction of interstate revenue paid into the fund to keep it solvent.

The FCC has responded to those concerns by freezing or capping various components of the

programs while it considers more substantial reforms, but the temporary arrangements have

remained in place because a politically feasible path for reform has not been found.


The bar chart in Figure 5 and the associated numbers provide further insight into the

expenditures of the high-cost fund.

Almost half of the high-cost payments go to small incumbent telephone companies (those

with fewer than 50,000 loops), while the remainder is split between larger incumbent companies

and the competitors to the high-cost companies that use wireless technology and receive the

same subsidy per line as the incumbent with which they compete.42

C. Payments and Contributions by individual states

Based on detailed industry data collected in FCC databases and agency staff estimates of

the contributions by state, it is possible to estimate the net flow of funds to or from the USF for

42

Universal Service Monitoring Report, 2009, Tables 3.14, 3.31, 2.4, 4.2, & 5.2

$2,053 (48%)

$866

$1,815

$53

$1,059 (25%) $1,177 (27%)

$0 $1,000 $2,000 $3,000 $4,000 $5,000

High Cost

Low Income

Schools and

Libraries

Rural Health Care

Payments (constant 2010 dollars in millions)

Figure 5 Universal Service Fund Payments 2007

High Cost <50,000 loops High Cost >50,000 loops

Source: Authors' analysis of Universal Service Monitoring Report, 2009, Tables 3.14,

3.31, 2.4, 4.2, & 5.2


each state.43 In general, USF subsidies flow from urban to rural areas because most of the

contributions to the fund come from urban areas and a large share of the payments go to rural

areas. It is not surprising, therefore, that comparing the net flow of funding between states

shows subsidies flowing from predominantly urban to predominantly rural states (see Figure 6).

The largest net contributors are the densely populated Northeastern states, and the largest net

recipients are the sparsely populated Midwestern and Mountain States, along with Alaska.44

Source: Authors’ analysis of FCC Universal Service Monitoring Report, December 2009, Tables 3.17 and 1.12

43

Universal Service Monitoring Report, 2009, Table 3.17 and 1.12. The methodology used in the staff estimates is

explained in the 2009 Monitoring Report, pp. 1-9 to 1-12, and the estimated contributions by state are contained in

Table 1.12 on that report. 44

Universal Service Monitoring Report, 2009, Table 3.14. Nevada is unusual because it is sparsely populated and

still makes a net contribution to the fund. Nevada's population is concentrated in the Las Vegas and Reno

metropolitan areas, with very few people in the remainder of the state and, therefore, it participates in the USF more

like an urban state than a rural state.


Examining the net flows in more detail, the largest net contributor is Delaware, at $55 per

line, indicating that telephone bills in the state are about $4.60 per month higher than they would

be if Delaware subscribers only contributed enough money to pay the benefits provided to state

residents (see Table 2). Alaska is by far the largest net recipient at $620 per year per line,

suggesting that telephone bills there would be $51.70 per month higher than at present with no

net subsidy.45 Although the net contributors are relatively close together, there is a large gap in

the net recipients between Alaska and the second-highest recipient, South Dakota, at $309 per

year per line or $25.75 average increase in the phone bill without subsidies if everything else

stayed the same.

Table 2 USF Payments: Net Flow Losses/Gains for 2008

State Net Payment Flow per Loop (dollars/yr)

Top

US

F N

et

Con

trib

uto

rs Delaware -$55.27

Rhode Island -$46.28

Maryland -$45.92

Massachusetts -$42.87

New Jersey -$41.74

Top

US

F N

et

Rec

ipie

nts

Alaska $619.80

South Dakota $309.07

North Dakota $303.39

Mississippi $230.87

Wyoming $200.22 Source: Authors’ analysis of the Universal Service Monitoring Report, 2009, Tables

3.17 and 1.12

V. Conclusion

The universal service program illustrates several characteristics of regulatory subsidies.

The program’s evolution through three forms of managing the subsidies (control of the rate

45

That computation assumes that everything else remains the same and Alaska telephone subscribers simply pay the

extra cost. With that large of an increase, multiple responses should be expected: some subscribers would give up

phone service or switch to satellite phones, some telephone companies would find cheaper ways of providing service

without the federal payments that are dependent upon showing high costs, etc.


structure, control of the interconnection conditions, and explicit charges and payments) shows

alternative ways in which regulation can create subsidies. The persistence of the program even

when threatened by changing technology and industry structure is observed in other industries:

Once subsidies are granted, the beneficiaries generate political pressure to continue them.

The evolution in the methods by which the subsidies were managed was accompanied by

an evolution in their substantive nature. The early phase of the program (pre-1984) provided a

flow of subsidy funds from the users of interstate long-distance service to the providers of local

service. During the second phase (1984-1996), the source of subsidy funds continued to be the

users of interstate long-distance service, but the subsidy funds were more narrowly targeted to

the providers of local service in rural areas, with particularly generous provisions for the smallest

companies. The long-distance-to-local-service subsidy for the large companies in urban areas

was phased out and replaced by a subsidy for low-income subscribers designed to prevent them

from dropping service as local rates rose. During the third phase (1997-present), the funding

source shifted toward users of cellular telephones (in addition to earlier sources of subsidy funds)

in order to continue generating the revenue to support the growing program. Subsidy payments

for high-cost companies and low-income individuals were increased over the earlier program and

new subsidies for Internet service to schools and libraries were added.

The program creates a flow of funds from urban to rural areas. The largest source of

funds is generated by raising the price of cellular service by approximately 5 percent (the

percentage of cellular revenue paid into the fund) and cellular users are concentrated in urban

areas. Most of the funds go to small rural companies. On a state- wide basis, Delaware’s

residents are the largest net contributors to the fund and Alaskans are the leading recipients.


The urban-to-rural flow of funds also occurs within states. Most states have small rural

telephone companies that receive payments from the fund, even if the state is a net contributor to

the fund on a state-wide basis. In a state with both urban and rural areas, such as Ohio, urban

residents are net contributors to the fund and rural companies and their customers are net

recipients. Detailed data on payments to individual telephone companies within each state are

available,46

but data on net intrastate flows comparable to the data on net interstate flows are not.

Because the USF is an explicit subsidy system with extensive publicly available data, the

costs and benefits in an accounting sense are clear. The cost is the required contribution into the

fund by telephone companies and normally assessed to corresponding customer services that was

approximately 14 percent of interstate long-distance revenue and 5 percent of cellular revenue in

2010. The benefits are the subsidies provided for high-cost companies, for communication and

Internet services for schools and libraries, for basic telephone service for low-income

individuals, and for communication services for rural health-care providers.

However, in an economic sense, the costs and benefits of the subsidy system are difficult

to determine because they depend on the assumed counterfactual situation that would have

occurred without the USF. If one assumes that currently subsidized telephone subscribers would

give up service in the absence of the USF, the subsidy program creates large social benefits. If

one assumes that unsubsidized wireless services would be widely used in rural areas in the

absence of the USF, the program limits incentives for technological change and creates few

social benefits. If one assumes that currently subsidized telephone subscribers would choose

their services but pay higher prices without the USF, the program simply transfers money from

urban to rural areas. It is beyond the scope of this paper to specify a plausible counterfactual

46

FCC Monitoring Report, Table 3.30


situation and to estimate the fund’s economic costs and benefits. The future of the universal

service program is uncertain. The legal basis for collecting the funds for the subsidies depends

on the distinction between “interstate” and “intrastate” service, and on the distinction between

“telecommunication service” and “information service.” Those four terms have specific legal

meanings and are used to designate the boundaries of the FCC’s regulatory authority and of its

authority to compel contributions into the USF. Changing technology and pricing practices have

muddled the older legal distinctions and created uncertainty about how to continue funding the

system.47

Furthermore, the FCC has announced plans to shift a portion of the subsidies into

efforts to promote broadband Internet service in rural areas, but has not specified how that will

be done and how the existing subsidies would be affected.48

However, the past adaptation of the

program to new circumstances suggests that a way will be found to continue the program, with

many of the same characteristics and beneficiaries as in the current program.

47

For example, Internet services are currently classified as “information services” and are exempt from

contributions into the USF. If Internet communication displaces traditional communication (a computer to computer

call instead of an ordinary telephone call), that displacement reduces funding for the USF. Similarly, the FCC only

can assess contributions from interstate services, but distance-insensitive pricing plans limit the ability to clearly

separate interstate and intrastate revenue. 48

“Connecting America: The National Broadband Plan”, Federal Communications Commission, March 2010,

Chapter 8. Available at www.broadband.gov.


REFERENCES

Brock, Gerald. Telecommunication Policy for the Information Age: From Monopoly to

Competition, (Cambridge: Harvard University Press, 1994).

Brock, Gerald. “Unifying the Intercarrier Compensation Regime,” In New Directions in

Communications Policy, Ed. Randolph J. May (Durham: Carolina Academic Press,

2009).

“Consumer Qualification for Lifeline.” Title 47 C.F.R. §54.409. (2002).

“Dissenting Statement of Commissioner Anne P. Jones,” CC Docket 80-286 (released September

26, 1983).

Federal Communications Commission, “Connecting America: The National Broadband Plan,”

March 2010. Available online at: www.broadband.gov.

Federal Communications Commission, Industry Analysis and Technology Division, Wireline

Competition Bureau, “Trends in Telephone Service,” September 2010. Available online

at: http://www.fcc.gov/reports/trends-telephony-service-2010.

Federal Communications Commission, “Telecommunications Industry Revenues,” September 2010.

Horwitz, Robert. The Irony of Regulatory Reform: The Deregulation of American

Telecommunications (New York: Oxford University Press, 1989).

Hundt, Reed E. You Say You Want a Revolution: A Story of Information Age Politics (New

Haven: Yale University Press, 2000).

Universal Service Contribution Methodology, FCC 06-94, 21 FCC Record 7518 (2006).

Available online at: http://www.universalservice.org/_res/documents/about/pdf/fcc-

orders/2006-fcc-orders/FCC-06-94.pdf.

Universal Service Monitoring Report, CC Docket No. 98-202, Prepared by Federal and State

Staff for the Federal-State Joint Board on Universal Service, December 2009. Available

online at: http://hraunfoss.fcc.gov/edocs_public/attachmatch/DOC-295442A1.pdf.

http://www.broadband.gov/

http://www.fcc.gov/reports/trends-telephony-service-2010

http://www.universalservice.org/_res/documents/about/pdf/fcc-orders/2006-fcc-orders/FCC-06-94.pdf

http://www.universalservice.org/_res/documents/about/pdf/fcc-orders/2006-fcc-orders/FCC-06-94.pdf


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